Tag Archives | option traders

The Option Greeks and the Passage of Time

In one of my live interactive meetings with Gold Members at Options for Rookies Premium, we were talking about the passage of time and whether option premium (and thus, bid/ask quotes) were adjusted smoothly with the passage of time or whether they ‘jumped’ each morning as a result of it now being ‘one day later.’ This is a typical (good) question from someone who is new to trading options.

By the way, the answer to the above question is ‘neither.’ Other bloggers, including Mark Sebastian, have discussed this point in detail (Option Pit) , but let me say that market makers have a system for marking the passage of time. My guess is that each uses a proprietary method and that everyone’s timepiece would not read the same time. In simple terms, the ticking clock speeds up as we move from Monday to Friday.

Regardless of the specific details, the people who set the markets accelerate time decay as the end of the week approaches. In other words, the theoretical clock ticks much faster on Friday than on the previous Monday. Why would market makers do this? It’s an attempt to smooth out the passage of time when taking into consideration that the markets are not open for trading on the weekends.

If the option traders used the ‘true’ Friday theoretical values for their bids and offers, when Monday morning arrived each option would (assuming an unchanged sock price) be lower than on Friday. This would be especially obvious as expiration week arrives. To discourage others from ‘dumping’ option premium of Friday and repurchasing Monday, the passage of time used to determine the value of an options is not measured in real time – at least not as weekends approach.

Whether this is a good idea (no markets are open over the weekend) or a bad idea (wars can start over a weekend) is not the point.

That discussion brought us to more questions about how time affects other greeks (in addition to theta). Does delta, gamma, vega change as time passes? The answer is yes, it does. Most of the time, beginners are not introduced to these concepts because they are not important factors on a day to day basis. There are general themes that are important (such as how does delta change as expiration nears), but the details are often overlooked. The math gets complex, but as will all math used in the options world, we have calculators to do the difficult tasks.

With that background, I believe it’s a good idea to introduce you to some of the second order greeks – with the understanding that this is basically a FYI discussion. If you want to get a deeper glimpse into the world of risk measurement when using options (the greeks), read on.

The following is from Wikipedia

Higher-order Greeks

Charm

Charm, or delta decay, measures the instantaneous rate of change of delta over the passage of time. Charm has also been called DdeltaDtime [the rate of change of delta with respect to time]. Charm can be an important Greek to measure/monitor when delta-hedging a position over the weekend. Charm is a second-order derivative of the option value, once to price and once to the passage of time. It is also the derivative of theta with respect to the price of the underlying

Practical use

The mathematical result of the formula for charm is expressed in delta/year. It is often useful to divide this by the number of days per year to arrive at the delta decay per day.

This use is fairly accurate when the time to option expiration is large. When an option nears expiration, charm itself may change quickly, rendering full day estimates inaccurate.

Color

Color, or gamma decay (or DgammaDtime) measures the rate of change of gamma over the passage of time. Color is a third-order derivative of the option value, twice to underlying asset price and once to time.

Color can be important to monitor when maintaining a gamma-hedged portfolio. It can help the trader anticipate the effectiveness of the hedge as time passes.

Practical use

The mathematical result is expressed in gamma/year. It is often useful to divide this by the number of days per year to arrive at the change in gamma per day. This use is fairly accurate when time to expiration is large. When an option nears expiration, color itself may change quickly, rendering full day estimates inaccurate.

DvegaDtime

DvegaDtime, measures the rate of change of vega with respect to the passage of time. DvegaDtime is the second derivative of the value function; once to volatility and once to time.

Practical use

It is common practice to divide the mathematical result of DvegaDtime by 100 times the number of days per year to reduce the value to the percentage change in vega per one day.

There are other 2nd and 3rd order greeks. Today’s discussion is untended to introduce you to the fact that the greeks are all sensitive to the passage of time. And as with the first order greeks with which we are familiar, an approaching expiration date can produce sharp changes in their values.

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Setting Profit Targets When Trading Iron Condor

Mark,

What is your personal definition of success in IC trading
represented by percentage return.

For an account that is trading over a 12 month
period what would you consider to be a good vs. superior return?

And
would these same numbers be representative on a year to year basis?


Thanks,

Don

***

This is a question that reappears at regular intervals.  I cannot offer a good answer for option traders.  More than that, I believe the question is inappropriate. What I deem 'good,' someone else may not.  In addition:

  • You are not in competition with anyone
  • You are not playing by the same (self-imposed) rules as others
  • You chose different spreads at different times and at different prices
  • You adjust more quickly or more slowly than others
  • You have a different investment goal
  • You have a different plan
  • You are more aggressive or more conservative
  • You trade big or small size
  • You max out your available margin, or you maintain plenty in reserve

How can anyone define a good return for each and every one of these (and more) possibilities?  Yes, I know you asked about my personal definition, but unless you know where on stand on the issues raised in the above list, how can the number that I give you have any relevance?

***

Don,

You must understand that my personal definition is very dependent on my style of trading, so I ask: How can this answer
have any value to you?

If you are a risk-taker, you must seek a high reward. I would
classify that as 4-5% per month.
If you are very conservative, then 1% per month would be an outstanding
return. Very conservative investors would be ecstatic to earn a return of 12%.

As for me, I'd be happy to average 2% per month on a continuing basis.
That includes allowing for negative months.  That meets my definition of 'good.'

As for year to year return, it's the same 2% per month, which is 24% per
year. However, if I were not withdrawing funds and wanted to compound
earnings, then 2% per month compounded is almost 27% per year.
As I said, I don't see how that tells you anything useful.

From my perspective, superior returns are a matter of good luck. Many months I
earn over 10% without doing anything different.  That's because no adjustments are needed and the options
just fade away – until I repurchase. No skill is required on my part. No
special trades are made to increase results. Just good luck. If I collect $300 premium on a 10-point iron condor and exit by paying $50, then I make $250 when using $700 margin.  That's a 36% return.  And that is a superior result – regardless of whether that takes one, two, or even three months.  It's also far more than I planned to earn when entering into the trade.

I have zero control over how often that happens.  I have no control over how much I may earn when everything is perfect.  All I can control is when to exit or adjust a trade and how much of a loss to take before closing.

My conclusion: Extraordinary returns for an iron condor trader are based on good fortune and such gains are needed on occasion, to cancel losing months.  But if you play for these great results and ignore risk, you will have situations in which the trade mentioned above will lose $700 instead of earning $250.  You cannot achieve superior results when taking such chances.

I define superior as better than 'good.' If you earn 35% per year, consider that to be superior to outstanding – if you do it on a consistent basis. It doesn't signify anything if you do it once.

Don, I hate to see you, or anyone, focus on these numbers. When you
trade iron condors, the actual results are going to be determined by
whether you  exit trades at a loss, or whether you get to ride the
position for a big profit. You can control when to take losses, but have no control over being allowed to comfortably do nothing.

What you can control is how greedy you are and when you cover winning
trades.

What you can control is determining the point at which you make
adjustments.

Do you give up some profits to adjust early, or do you wait until your IC has moved ITM? These alternatives
make a huge difference in your results.
By focusing on earning a specific 'number of dollars,' you may delay when it's important to make an adjustment.  Although it can go either way, this is likely to be a costly error.

If you ignore the numbers and only look at
them after the fact (position closed), then you can decide whether you are meeting your
goals.
If you are not earning enough to please yourself, look at your trades,
your trade plan, your trade journal, and try to figure out what you can change to increase rewards without taking unnecessary risk.  I surely cannot tell you what will work for you. 

Everyone wants to earn a fortune when things are going well, and
increasing position size by 10% may be a reasonable thing to do.  However, be careful not to get too greedy.

When it hits the fan, you must be prepared to earn less, or even lose money, and concentrate on protecting your
assets – assuming you continue to trade iron condors in a volatile market.

I understand your anguish.  I get it when you want profit targets.  To me, trading is working with statistics.  You know your future contains some periods of time that are devastating for uninsured iron condor traders.  You also know that sometimes the markets move up and down, yet remain within your safe range.  In my opinion, this is a matter of luck.  However, if you are a trader who uses technical analysis to choose strike prices, and believe that it works, then good luck may be the result of skillfully selecting appropriate strike prices.

Your job is to make a good trade (based on conditions at the time) and to manage it well.  If you do that, you will not need targets to see that you have been successful.

738

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a) Rookie's Guide to Options: Sampler 

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Expiring Monthly: Back Issue Giveaway

Promotion ended 5/2/2010.
The article with the most votes is: 'Predicting Stock Returns with Implied Volatility', written by Jared Woodard. As promised, here's the link to that article.

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Expiring Monthly is an electronic magazine, and 100% devoted to options.

Below is the Table of Contents for the inaugural issue, March 2010. 


1003_TOC

To enter the contest, choose the single article you would most like to read. Post a comment (on this post) and include the tile of the article that gets your vote. The title is sufficient; no additional commentary is necessary to enter.

At least three readers, whose comment is randomly selected, will receive the March 2010 issue via email.

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